The guiding principles in the 2017 Tax Cuts and Jobs Act (“TCJA”) enacted in December 2017 were to create jobs, stimulate economic growth, and make American businesses more competitive in the global marketplace. The key focus of this new comprehensive legislation was to provide overall tax reductions for businesses. This was accomplished mainly by lowering the business tax rates and enhancing the deductions for capital expenditures (“CapEx”). In addition, a whole new regime for international taxation was introduced.
There was an entire host of other tax changes enacted as part of TCJA—some favorable and others not. All these changes will impact businesses’ tax situations, but they will also alter the strategy of stakeholders in these businesses including Private Equity Firms (PEF). This article addresses select provisions in the TCJA and the possible impact they may have on PEF.
Tax Rates on Business and Entity Selection
As noted, TCJA offers significant reductions in businesses’ tax rates (businesses affected include both C Corporations and pass-through businesses—Partnerships/LLCs and S Corporations).
The tax rate for C Corporations was cut from a 34/35% rate to a flat 21% rate effective 2018. This lower tax rate is designed to position the United States as more competitive with the rest of the world. While not the lowest global rate, it is not the highest either (as it had been before tax reform).
Congress also wanted to lower the tax rate on pass-through businesses, as these enterprises generate jobs and positively impact the economy. TCJA offers a new 20% deduction for “Qualified Business Income” (new Section 199A) to owners of pass-through businesses. To the extent the trade or business meets all the requirements and qualifies for this deduction, the top tax rate drops from 37% to 29.6%. The details of this new 20% deduction were addressed in a prior Sikich tax alert (please click here for more information).
How Tax Rate Changes Might Impact Private Equity Firms
It is important for a PEF to evaluate not only these new tax rates for the business enterprises it owns, but also for its own operations and management. A PEF will need to evaluate each business it’s invests in to determine what type of entity should be utilized. Some of the factors to address are:
- The projected income of the business in the coming years
- Whether or not the business qualifies for the new 20% deduction (Section 199A)
- The anticipated plans for the business, including its exit strategy
- Any international considerations of the business that might favor C Corporation status and not be available for a pass-through business
- State tax considerations
- And many other factors
It is important for the PEF to model out this entity analysis for each company it owns. In some cases, a PEF may select a C Corporation, while in other instances a pass-through entity (likely a Partnership/LLC) or a combination of these could be used.
CapEx Considerations for Private Equity Firms
The TCJA made significant enhancements with CapEx:
- Bonus Depreciation Provisions – Increased to 100%: Congress expanded the bonus depreciation provisions from 50% to 100%. This new 100% applies for property acquired and placed in service after September 27, 2017. This is available for businesses large or small and across industry lines.
- Bonus Depreciation Provision – Used Property: One significant change was to allow bonus depreciation on both new and used property acquisitions, whereas previously it was only allowed on new property.
- Section 179 Expensing Limitation Doubled: This limitation was raised from $510,000 to $1,000,000, and the point at which these additions are phased out was raised to $2,500,000. These Section 179 changes apply for 2018.
As noted, one of the key changes from the TCJA was not only to raise the bonus depreciation to 100%, but also the ability now to take bonus depreciation on used property. This change will have a significant impact on the buying and selling of businesses, which PEF are regularly involved in. Many transactions today are structured as the sale/purchase of assets and not as a stock sale. This generally results in only one layer of tax by the seller. The buyer and seller not only negotiate the selling price of the assets, but also spend time deciding how this price is allocated among the various assets being sold or purchased.
For tax purposes, the purchase price allocation must follow a protocol that starts with cash and cash equivalents and moves next to inventory, receivables, and fixed assets (CapEx). Then it ends with intangible assets (often goodwill or going concern). Before TCJA, any amounts allocated in a transaction for CapEx (personal property; not real estate) were depreciated over five to seven years. Now under TCJA, CapEx is eligible for the 100% bonus depreciation, and it applies to used property.
Observation: Thus, Private Equity Firms may change the dynamic of how they allocate purchase price in transactions, in which they are the buyer, to maximize the up-front depreciation deductions from the allocation to CapEx and scale back on the amounts attributed to intangible assets that receive a 15-year shelf-life amortization period. On the other hand, a PEF performing as the seller may not be on board for such an allocation—as it could result in more ordinary income and less capital gain income. Thus, negotiations will need to resolve these matters.
New Limitation on Interest Expense Deduction
The TJCA adopts a new limitation on the deductibility of business interest expense (please click here for our Sikich article on this topic). The new rule limits the deductibility of business interest to 30% of Adjusted Taxable Income (“ATI”). ATI is defined as the taxable income of the business. However, it does not include: any business interest income of the company, Net Operating Loss (NOL) of the business, tax depreciation or amortization deductions of the company, or the deductible business interest expense.
The 30% deduction begins in 2018 and applies to businesses that are C Corporations and consolidated return groups. There are also special complex rules for calculating this 30% limitation for pass-through businesses and their owners. As many PEF utilize partnerships, this is an item they will need to focus on. The recent regulations are extremely complex especially where PEF function in the partnership venue.
Exceptions. As with most parts of the tax law there are exceptions, and this is the case with the new interest provisions. First, there is a general exception to these new interest limitation provisions for a small business, which is defined by the new law as a business with gross receipts of less than $25 million (average of prior three years’ gross receipts). Thus, a smaller business does not need to be concerned with these new interest limitations. There are also exceptions for real estate businesses and agribusinesses to elect out of the new interest limitations. However, this election comes with the cost of not being able to claim bonus depreciation. Lastly, auto dealers with floor plan financing also avoid these new limits.
Any disallowed interest expense under this new 30% limitation carries forward indefinitely. It should also be noted that this depreciation and amortization modification indicated above will be removed after 2022, and this will lower ATI and may consequently trigger more interest expense being disallowed.
As PEF analyze this new interest limitation and determine if they will be significantly impacted, it may alter their approach to their funding model. The amount of debt committed to transactions by PEF may be scaled back because of this change. It is critical for PEF to review this new limitation for deducting interest expense.
A number of accounting method changes affect smaller businesses, specifically applying to the cash method of accounting, use of inventory, impact of UNICAP of inventory, and long-term contracts. Please note that there are rules to aggregate related businesses for purposes of the $25 million threshold, so these opportunities for accounting method changes may not affect PEF.
There were other TCJA revisions with methods of accounting that may impact PEF. One change specifies that income for tax purposes must be recognized no later than when it was recognized for book purposes (or on its financial statements). Thus, if a company had deferred income for tax purposes longer than for book purposes, it will need to evaluate this new rule and determine how to align its timing.
Guidance was issued by the IRS on these changes in method of accounting, and more is expected in the coming months.
“Carried Interests” Must be Carried Longer
PEF often utilize carried interests as part of their business model. A carried interest involves a situation where the taxpayer (again, generally a PEF) designates some of the allocated income of the business to certain parties (typically someone with the PEF). This carried interest has no initial value; but if the new business grows, the carried interest may in turn also grow in value. This income can be treated as capital gain and not ordinary income. The new law lengthened the holding period for carried interests to obtain long-term capital gain treatment from one year to three years. If the income is sold before three years, the carried interest holder will trigger short-term capital gain.
There were several changes related to partnerships. One such change involves the treatment of a “technical termination” by a partnership. Previously, if a partner (or partners) entered into the sale of >50% of partnership by the partners, then the partnership would be deemed to trigger a technical termination. The impact of this termination was to start the depreciation and amortization over at the partnership level, and this created additional reporting. TCJA removed this technical termination requirement. Now, a partnership termination only occurs when the partnership fully terminates by liquidating all its assets and liabilities.
Opportunity Zones – New Tax Incentive
The new Opportunity Zones offer several tax incentives for taxpayer-investors. We addressed this topic in a previous tax reform insight (please click here to read this article). The IRS recently issued its first set of regulations on the Opportunity Zones, and more is expected.
Congress wanted to provide incentives for taxpayers to invest in certain lower income areas to stimulate economic growth in these areas. These opportunity zones have already been established in every state and Washington, D.C.
To obtain the Opportunity Zone tax break, taxpayers must invest in an Opportunity Zone Fund, which is an organized investment vehicle targeted at businesses located in these zones. Taxpayer-investors obtain the following tax breaks:
- A gain deferral (gain deferred until 12/31/2026 unless disposed of earlier) of recognized gains if the eligible gains are reinvested in an Opportunity Zone Fund within 180 days of the transaction. Eligible gains include capital (long-term or short-term), Section 1231, and collectible gains. Thus, the short-term gain from the sale of a carried interest (with the new three-year holding period noted above) could qualify as an eligible gain for an investment into an Opportunity Fund;
- A 10% jump in the tax basis once the investment in the Opportunity Zone Fund is held for five years and another 5% after seven years;
- An exclusion of the eligible gain if the Opportunity Zone Fund investment is held for ten years. The taxpayer does this by making an election to adjust the basis of the Opportunity Zone Fund investment to its fair market value when the investment is sold (after this ten-year holding period).
The proposed regulations indicate that an eligible taxpayer is an individual “that may recognize gains for purposes of Federal income tax accounting.” Thus, the following taxpayers qualify to invest in Opportunity Zone Funds and can defer eligible gains:
- C Corporations, including Regulated Investment Companies (RICs – mutual funds)
- Real Estate Investment Trusts (REITs)
- S Corporations
- Trusts and estates
Thus, PEF could play several key roles with the new Opportunity Zones:
- First, any gain recognized by the PEF could be reinvested into an Opportunity Zone Fund. If the PEF does not utilize an Opportunity Zone Fund to defer a gain it recognizes, then its partners can separately make this investment.
- Further, PEF may set up certain funds that qualify as an Opportunity Zone Fund and then look for taxpayer-investors with recognized gains that would want to redeploy their capital gains into an Opportunity Zone Fund.
International and SALT Revisions
Some of the most comprehensive and complex changes in TCJA involved the international tax arena. There were wholesale changes made, and an entirely new tax regime applies with international tax situations. PEF should address these provisions closely if any of their business holdings have international operations.
In a similar manner, many of the changes outlined by the TCJA will have some corresponding ripple effect at the state level. These tax treatments vary from one state to another. PEF need to be diligent in their analysis of the state tax changes from TCJA and how it will impact them.
(A more thorough analysis of the international tax changes, as well as the State and Local Tax—SALT—changes is beyond the scope of this article. Impacted firms should be aware of the changing tax landscapes.)
Tax Incentives Not Pruned by TCJA
As is often the case, it is important to learn not only what is contained in a new tax legislation such as the TCJA, but also what was not in the tax bill. This includes tax incentives. Some of the tax saving provisions that survived TCJA included: the R&D Tax Credit, the LIFO Inventory method, and Section 1202 stock. PEF often take advantage of these tools and should be able to in the future (please click here for an article analyzing the merits of LIFO inventory).
PEF have played an instrumental role in the capital markets over the years, and this will not change because of TCJA. There are many opportunities for PEF and their taxpayer-investors to consider. There are also new limitations and reporting provisions to monitor. PEF that take the initiative to address and implement tax reform in their business will stay afloat in today’s turbulent marketplace, while those that avoid tax reform strategies may find themselves struggling to survive. Please contact your Sikich advisor with any questions on tax reform or for other assistance.